Oil Market Structure and Prices: A Behavioral Analysis Massood Samii, Ph.D.

Various Theories of Oil Prices Market Psychology OPEC Speculators Market Fundamentals Major Oil Companies

Oil Companies The major Oil companies had a great power in setting oil prices and in manipulating the market in 1950s and 1960s. ( Anthony Simpson The Seven Sisters: The great oil companies & the world they shaped, 1975 ) However, structural changes in the market including; nationalization by the oil producing countries, emergence of major oil traders, oil derivative market, National Oil Companies have some what reduced their international power. They still play an important role in pricing and market intervention

OPEC While OPEC emerged as an organization in 1960, it was not recognized as a major force in the global oil market until 1968 and 1973 prices increases. Question remains whether it was OPEC or the market fundamentals (including political conflicts) that led to the oil price increase of 1973, Samii, M. The Organization of the Petroleum Exporting Countries and the Oil Market: Difference of Views, Energy and Development, 1985, Vol.12 No.2 OPEC ability to manage the market – Assumption: OPEC is to stabilize the market and not to maximize revenue – Ability to stability is greatest when demand for OPEC falls within MBD

Market Fundamentals Supply and Demand are critical factor in the determination of oil prices. Emerging markets demand for Oil is now consider to be an important factor Peak Oil price ( Herburt King, Deffeyes, Kenneth (2002). Hubbert's Peak: The Impending World Oil Shortage. Princeton University Press Exchange rate ( Samii, M. and Clemenz C., Exchange rate fluctuation and Stability of Oil Market, Energy Policy Journal, August 1988, P.P )

Speculation Speculation in the oil market until mid 1980s was based on the crude oil storage and draw dawn from storage. Rise of oil derivative market change the picture. Today oil future market plays prominent role in shaping the oil prices ( Samii, M. Oil Futures and Spot Market, OPEC Review, winter 1992 ) Various form of speculation ( Razavi, H. and Samii, M. Speculative Demand for Oil, OPEC Review, 1983, and Samii, Wiener, Wirl Determinants of Crude Oil Prices: OPEC verses Speculators, Discussion Paper J.F. Kennedy School Harvard 1989 E-89-05) – Oil companies building stock along their value chain – Oil Future Market. Currently, amount of oil traded in the future market is more than 10 times the amount of World oil consumption of 85 MBD and thirty times that of OPEC oil production of around 30 MBD

Market Psychology What is behavioral economic and finance? – Behavioral economics builds on the concepts of emotion of individuals and institution on their decision-making that impacts the market and prices. (It challenges market efficiency theory) – The theory of Bounded rationality tries to explain how people irrationally attempt to gain satisfaction, violating the concept of utility maximization/value maximization – It leads to herd effect, over reaction to information, Over confidence, and Speculation. – In case of oil market, over reaction and speculation based on perceived political risks and disruptive events.

Some of the events that led to Oil Price speculation and Spike Iran-Iraq War Iraq Invasion of Kuwait Perceived shortness of the market because of rise in emerging market demand

Example WASHINGTON, Sept 10 (Reuters) - Institutional investors caused the rapid rise and subsequent steep fall in oil prices in 2008, according to an independent report released by U.S. lawmakers on Wednesday. The report, co-authored by hedge fund manager Michael Masters, said from January to May index traders poured $60 billion into commodity markets, causing a big spike in oil prices. When Congress held hearings in May to July about reining in speculation, traders pulled $39 billion from the market, the report stated. Oil hit a record $147 a barrel in July, and then started falling sharply until it reached $102 this week. Reuters September 10 /2008

Why Oil Market has become so Speculative There is no constraint in purchase in the futures market. In the Wet barrel, storage capacity and carrying cost limit stock build up. No such a constraint exists in the paper barrel market. Theory tells us that the future price must be higher than spot called Contango by carrying cost (storage and interest rate). But in many cases we observe a backwardation, that is the future price is below spot price for oil.